In the “best” category, large-cap European stocks in developed markets there, 55% of the funds underperformed over the past year. That result deteriorates pretty steadily as time progresses, with the result that on a ten-year view 87% underperform. .and that’s the best!

The race for last place is almost a dead heat among Global, Emerging Markets and US. Over the past year, 82% -83% of managers in these categories underperformed. This result also deteriorates over time. Over the past ten years, 97% – 98% underperformed.

This is the same pattern as for US active managers …only worse.

The performance figures are after all fees–management, administrative, marketing…–except for the sales charges levied by traditional brokers.

More importantly, the figures for each period include all funds active during that time, not just the ones that made it through the entire period. That’s key because over the past ten years about half of the funds active for part of the time were either shut down or (more likely) merged with other funds. It’s possible that one or two of the defunct funds were great performers but for some reason couldn’t be sold. However, in my experience, the overwhelming majority would have been folded because the performance was bad.

Similar figures for the survivors confirms my belief. The 10-year record for this smaller, hardier, group shows around half the funds outperforming their indices–except for the emerging markets category where over two-thirds of the surviving managers still underperform.

Why do clients put up with this?

One answer is that the absolute returns have been between 5% and 10% yearly in euros. On the low side that means up by almost 65% over the past decade. That’s not all that investors could reasonable have expected, but it’s not a loss. So alarm bells don’t go off when holders get their statements.

Another is that they aren’t. These sad figures for active managers are the biggest explanation for the popularity of passive products.

While I’m on the topic of investment styles, I figure I should say something about growth investing.

I started out as a value investor, concentrating on US companies. After a few years as a securities analyst, I began assisting a superb value investor who was running a short portfolio, again all US. A couple of years later, I changed jobs and started working as a portfolio manager in smaller Pacific Basin markets. There, I was immediately attracted to smaller cap stocks, which at that time had the unusual combination of the best business models, the fastest growth and the lowest PEs in their markets. What they didn’t have was a lot of market visibility, partly because they were so small and partly because the markets I was working in, like Australia and Hong Kong, were not very highly developed.

Yes, I continued to find stodgy old conglomerates where enormous value could be created by breaking them up and selling the pieces one by one, and others where an infusion of competent management could dramatically reverse declining fortunes. But I became more and more impressed by the raw earnings power of dynamic young firms. It was only when I was describing my investment process in an interview for another job that I realized I was no longer a value investor. I had become a growth investor instead!

My experience is that there’s a lot of confusion about what growth investing is. In a sense, this confusion is aided and abetted by us growth investors ourselves, since no one wants to give away professional secrets, especially while he’s still working.

For example, the media talk about momentum investing, meaning buying stocks based solely on the fact that they’re currently outperforming the market. This is an old offshoot of technical analysis, however, and has nothing to do with growth investing.

Then there’s “pure” growth investing, as practiced by the ill-fated Janus group in the 1990s. Here the investor (that’s probably not the right descriptive) buys stocks based on accelerating sales and earnings, but without regard to price. But doing so completely disregards a growth investor’s greatest challenge–knowing when to sell. To my mind, this is pure speculation, not growth investing.

Growth At a Reasonable Price (GARP) is a genuine, if to my mind odd, growth variation. Typically, a GARP investor sets a maximum PE ratio, say 25x the earnings likely over the next 12 months, as a maximum price he will pay for any stock, no matter how good the growth prospects. I’ve sometimes been described as a GARP investor, rather than a “pure” growth disciple. I find GARP too rigid, however. For instance, holding firm to 25x would have ruled out Apple for much of its growth period, even though the footnotes to the financials made it clear that the company was using extremely conservative accounting (since changed) to record the profits from its iPhone business.

I think genuine growth investing has four facets to it:

–the growth investor buys the stocks of companies he believes will grow earnings faster than the market expects and/or for a longer period than the market anticipates (hopefully, both)

–decisions must be based on meticulous analysis and projections of the financials of the company, done by the investor himself, at least in large part

Every professional investor, no matter how he describes what he does, looks to buy undervalued securities. That’s not unique to value investors, no matter how academics may insist otherwise. Growth stock investors seek this undervaluation in the market’s underestimation of a company’s future prospects, as measured by how fast earnings are growing, how the trajectory is accelerating and how long super-normal growth may continue. Value investors look for undervaluation in underestimation of the worth of companies’ here-and-now, based on metrics like price to book, price to cash flow and price to earnings.

Most often, value investors are attracted to companies that:

–are suffering from temporary misfortune–the wrong part of the business cycle or a management miscue–that the market mistakenly thinks is a permanent defect, or

–are badly run, but the market doesn’t realize that change is possible, either by action by the board of directors or by third parties forcing change of control.

In either case, the presumption is that cumulative spending on property, physical plant and equipment or on intangibles like brand names, patents, distribution networks or building brand names through advertising and marketing all have an enduring value that will most likely grow with time. In the worst case, the worth of these assets will erode only very slowly.

This assumption is value investing’s chief problem, I think.

How so?

–through e-commerce and social media, the internet continues to erode the value of traditional distribution networks and the power of the decades of advertising and marketing spending that have established and (until a decade or so ago) protected them

—generational change. The gradual but steady replacement of the Baby Boom by younger generations who want to distinguish themselves from their parents means not only a change in what categories consumers spend on but a change in tastes, implying traditional firms may not benefit

—the Great Recession. In my experience, big economic downturns most often trigger changes in behavior. They’re the reason for reassessing and changing spending habits. They are also, if nothing else, the excuse for severing traditional relationships. Some of this is economic necessity, some not. Gen-Xers, for example, congregate in cities instead of the suburbs where their parents live. They can’t afford to get sick and miss work, and they can’t afford restaurant meals, so they avoid fast food and make healthy meals at home. They use mass transportation rather than owning a car. Macys and McDonalds are the last places you’ll find them.

These three developments all attack the traditional order, and thereby undermine the assumption of the relative permanence of asset value for many firms. This phenomenon is greatest in consumer-facing enterprises, less so in industrial.

The result is, I think, that value investors have to become more like their growth colleagues in investigating in great depth a firm’s ability to withstand the disruptive forces I’ve just listed. Buying and selling based on screens of low price to book, low price to cash flow and low price to earnings is no longer enough

The gist of the post is that both over the past one- and ten-year periods, value investing strategies have generally, and pretty steadily, underperformed the S&P. The author, Tim Edwards, senior director of index investment strategy for S&P, suggests that this may be because value investing has become too popular. In his words, “With so much energy directed to exploiting the excess returns available through value investing, maybe the only “value” stocks left are the value traps, those stocks whose prices are low as their prospects are determinedly poor.”

my semi-random thoughts

Value investing has been around at least since the 1930s and is the dominant investment style for professionals worldwide. Growth stock investing may be a close second to value in the US but is a non-starter elsewhere.

Value investing does not mean buying stocks that are cheap relative to their future prospects, i.e., bargains. Rather, it’s a rule-governed process of buying, depending on the flavor of value an adherent espouses, the stocks with the lowest price to earnings, price to cash flow or price to net assets ratio–on the idea that the market has already factored into prices the worst that can possible happen, and then some. So once the market begins to turn an objective eye toward such stocks once more, their prices will rise. At the same time, downside is limited because the stocks can’t fall off the floor.

As a dyed-in-the-wool growth stock investor (who has worked side by side with value colleagues for virtually all of his professional career), my observation is that value stock indices routinely include growth stocks. Growth indices, in contrast, are often salted with stocks that are well past their best-by date and that are ticking time bombs no self-respecting growth stock investor would own. Academics use these mischaracterized indices to “prove” the superiority of value over growth. Indexers use similar methodologies. Be that as it may, this is another reason for surprise at the years-long underperformance of value.

Early in my career I became acquainted with a married couple, where the husband was an excellent growth stock investor, the wife a similarly accomplished value stock picker. She outperformed him in the first two years of a business cycle; he outperformed her in the next two years. Their long-term records were identical. This is how value and growth worked until the late 1990s.

The late 1990s produced a super-long growth cycle that culminated in the Internet bust of 2000. That was followed by a super value cycle that ran most of the next 4-5 years. Both were a break with past patterns. The strength of the second may be a reason value has looked so bad since.

5. Still, what I find surprising about the past decade is the persistent underperformance of value, despite the birth of a post-Great Recession business cycle in 2009. The cycle turn has always been the prime period of value outperformance. Why not now? …the Internet.

The outstanding characteristic of the US stock market vs. other national markets during my career has been that Wall Street has been, almost uniquely, dominated by stock pickers. While political or macroeconomic concerns occasionally arise, the focus of the vast majority of stock market participants has been on the merits (or lack of them) of individual stocks.

Many veteran stock pickers on the sell side have either retired or been laid off over the past several years, however, and institutional pension money allocated to active investing has increasingly been funneled to trading-oriented hedge funds or other “alternative” investment vehicles in a so-far vain attempt to close the gap between the assets they have on hand and the minimum they need to meet their present and future obligations.

The result of this change has been an increasing influence on stock prices by computers that react to news of all sorts as it is published and by short-term human traders sensitive to macroeconomic trends but with (to me) surprisingly little knowledge of the ins and outs of individual companies or industries.

My worry has been that–as has happened in other countries–the macro woes of sectors like Energy and Materials, or perhaps the demise of the post-WWII industrial corporate structure, overwhelm the attractions of even large micro pockets of strength in, say, IT.

last Friday

My worries have no basis in fact, at least so far, if last Friday’s trade is any indication.

The S&P 500 was up by 1.1%, the IT-heavy NASDAQ by 2.3%. However, consider the performance of the following companies that reported earnings before the open:

Microsoft +10.0%

Alphabet (aka Google) +7.7%

Amazon +6.2%

athenahealth (a weak performer before Friday) +27.5%.

Compare that with:

VF -12.9%

Skechers -31.6&

Pandora Media -35.6%%.

Two things stand out to me:

–most of these reactions are extreme, suggesting that the market is reacting to the news rather than anticipating it, and

–the market is very willing to differentiate sharply between individual winners and losers.

My conclusion: we as individuals can still ply our stock-selecting trade. The reward for finding superior companies, however, may come all at once, and later than we have been used to in the past.

Consider the case of a Japanese company that makes cars in Brazil, which it then sells in the US. Its internal control books will allocate a portion of the revenues and costs of a given car to operations in Japan for use of the brand name and the firm’s intellectual property, another portion to the manufacturing operations in Brazil and a third to the sales operations in the US.

This allocation process is called transfer pricing. This in itself is a benign process. After all, the firm has to understand whether Brazil is a profitable place to make cars and whether the Brazilian output should be allocated to the US or to other, potentially more profitable, markets.

What makes transfer pricing controversial, however, is that the firm also has tax books. And the logic that dictates the management control profit decisions may not be the same as the one that minimizes taxes.

An example:

When I began working as a global portfolio manager in the mid-1980s, Tokyo was a very important stock market. Multinational brokers all had lavish offices in swanky downtown districts and very large staffs–all of which seemed to be growing by the day. Yet, I kept reading, at my then glacial, now non-existent, kanji speed–in the Nihon Keizai Shimbun that these same brokers were losing tens of millions of dollars a year. This state of affairs had been going on for years, with no relief in sight.

I began asking around. What I learned , after a long time of digging, was that all of the Japanese securities trades that customers placed with these brokers were funneled through their Hong Kong offices. In an operational sense, this was crazy. I knew most of the Hong Kong operations of these firms. They knew nothing about Japan, in my opinion. And, of course, this was an extra, possible mistake-inducing, step. Why?

The answer is simple. Japan had, along with the US, the highest corporate tax rates in the world. In Hong Kong, the tax on foreign corporations’ profits was zero. So every foreigner in any line of business established a Hong Kong office and recognized on its tax books as much international profit there as it thought it could get away with.

What’s in this for Hong Kong ? Again, simple. The move created employment, commerce and taxable salary income that the now-SAR would not have had otherwise. The price was only forgoing tax income it would never have had anyway.

The general transfer pricing tax strategy: recognize as much profit as possible in low-tax jurisdictions, the minimum amount in high-tax locations.

turning to the EU today…

Margrethe Vestager, the new EU competition commissioner, is starting a crackdown on what the union considers abusive tax practices. Her first targets are Starbucks and Fiat.

In the Starbucks case, Vestager has two gripes. Both relate to a low-tax corporate subsidiary set up by Starbucks in the Netherlands, using an aggressive tax strategy endorsed as legal by that government thorough an informal tax letter. (The situation is outlined best, I think, in a New York Times article). The subsidiary allegedly:

–bought coffee beans for Starbucks worldwide from Switzerland and marked them up by 20% before selling them to other parts of the company, thus shifting profits away from higher-tax jurisdictions around the globe, and

–levied charges for the use in the EU of the Starbucks name and its secret coffee roasting recipe (which the EU competition commission claims was basically a temperature setting). In the case of the large UK subsidiary of Starbucks these fees for intellectual property apparently amounted to most of its pre-tax income.

Vestager is not saying that Starbucks, Fiat and others did anything wrong. She’s saying the Netherlands, and other countries that offered sweetheart tax deals did. And she wants those countries to collect back taxes.

It will be interesting to see what develops, since presumably every multinational doing business in the EU is employing similar devices.

There’s no overall theory of how world currencies interact with one another. Rather, there’s patchwork of general relationships. I find two most useful:

—general creditworthiness, or would I lend money to these guys (WILMTTG)?.

Another way of asking the same question is whether a country can generate enough foreign exchange to pay for its imports and meet the minimum service requirements on its foreign borrowings. A “No” answer means trouble.

Natural resources-oriented emerging countries, both in the Middle East and in Latin America, are going to flunk this test, suggesting that for them currency depreciation is in store.

—relative interest rates

Generally speaking, countries where interest rates are rising will have stronger currencies than those where rates are stable or falling.

This rule suggests that the US$ will continue to rise against the euro, yen renminbi and emerging markets currencies–meaning just about everything.

As a practical matter, domestic stock markets seem to work best when a currency is stable or depreciating slightly. A rising currency, because it lowers the domestic currency value of foreign earnings, acts as an earnings headwind.

I’ve found that the currency markets–read: traders in the big multinational commercial banks–are always three or four steps ahead of me in figuring out where currencies are going. For equity investors, there may also be an issue of how the companies whose stocks they hold are acting internally to hedge their foreign currency exposure.

Typically, this second isn’t as big an issue as it might seem at first. Stock markets most often understand that hedges now protecting profits will soon expire and, in consequence, pretty much ignore the earnings per share generated by hedging.

The question of what’s already baked in the currency trading cake is a more serious one. It has me questioning whether any interest rate rises that may come in the US next year aren’t already factored into today’s currency rates.

my conclusions

The US$ will be flat to up vs. all other currencies next year.

The yen will be down, on my “No!” answer to the WILMTTG question.

Emerging market currencies will generally be weak.

The renminbi will be flattish, on weak relative rates but “Yes to WILMTTG.

Too soon to act on, but will the euro be stronger in the second half?

stock market implications

All other things being equal, companies with costs in weak currencies and revenues in strong currencies will have the best financial results.

Multinational companies based in the US with exposure to natural resources emerging markets may do poorly.

Those with EU exposure may show slim growth, if any, in their operations there in the first half. Better news in the second?

As a general rule, when the domestic currency is rising, look for purely domestic companies and for importers.